3 Beaten-Up Cheap Stocks: Are They Bargains?

With the broader market trading at such high prices these days, it almost seems strange when an individual company's stock trades at a discount. Either the market is undervaluing the longer-term future because of something in the short term, or there is something wrong with the company and it's cheap for a reason.

Three companies that have been hit particularly hard and are trading at low valuations are offshore rig owner Diamond Offshore Drilling (NYSE: DO), oil and gas producer Denbury Resources (NYSE: DNR), and airline Hawaiian Holdings (NASDAQ: HA). Let's look at each situation to see if the market is overreacting to something, or if there are some deeper problems with these stocks.

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In a better position to ride out the storm

I dare you to find an industry that has been hit as hard as the offshore rig industry over the past several years. Declining oil prices and the economics of shale drilling drastically improving have made offshore drilling one of the most out-of-favor industries out there. Just about every offshore rig company currently trades at well below its tangible book value, and that is after billions in asset impairments and writedowns.

The one outlier among the group is Diamond Offshore, which trades at a "premium" of 0.39 times tangible book. The reason the market is so much more optimistic about this company is that it has so far been the only company able to gain a sufficient amount of contract work to increase revenue. It also helps that the company has moved quickly to shed its older rigs that aren't likely to get work again.

Based on the total contract backlog Diamond has and its balance sheet, the company is in a better position than most to do well once the demand for offshore exploration and development picks back up again. With shares trading for pennies on the dollar of book value, it seems like an investment in Diamond could reap big rewards in a couple of years.

A misunderstood oil investment?

Investors looking at independent oil and gas producers in North America have focused almost entirely on one metric -- growth. Companies that can grow production at today's prices without breaking the bank have been treated far better than others. Take, for example, Denbury Resources. Unlike producers working in the shale patch, Denbury elects to tap older reserves that were considered spent and uses an enhanced recovery technique known as CO2 injection. It is a slower method of extracting oil that takes more upfront capital to start the injection process, but it tends to be a steady oil source for years with little production decline and almost no exploration expenditures.

Even though Denbury can't grow production quickly, the oil it does produce is profitable at today's prices. In Denbury's most recent earnings release, management said it was able to raise its production guidance for the year while reducing capital expenditures.

With shares trading at less than tangible book value, the market isn't too hopeful that Denbury will be able to get through this low price environment without some significant sales or further asset impairments. The company's recent results seem to suggest otherwise. Management has shown that enhanced recovery can be cost competitive with shale. That said, the company still needs oil prices to be higher to deliver value to investors. While the chances of higher prices in the future are likely, it isn't a certainty.

A lot of fear of impending competition

So far in 2017, shares of Hawaiian Holdings are down more than 25%. That is despite the fact that Hawaiian continues to post some of the best unit revenue metrics in the airline business. Hawaiian's revenue per available seat mile so far in 2017 has increased adjusted pre-tax income by 30%, and that includes cost increases related to higher fuel prices and training costs for its incoming fleet of Airbus A321neos. Hawaiian has consistently had some of the highest profit margin among the major carriers in the U.S., yet its stock trades at the lowest valuation, with an enterprise value to earnings before interest, taxes, depreciation, and amortization ratio of 4.2 times.

Wall Street seems to be scared off from Hawaiian stock for two reasons. First, its costs continue to rise because of higher wages, and second, its competitors are about to stomp on its turf. United Continental alone plans to add 11 extra daily flights to Hawaii in 2018, and other airlines plan to add quite a bit of capacity to the Hawaiian Islands, as well. With capacity expected to grow in the double digits between now and next year, the fear is that competition will put pressure on prices and will likely cause a deterioration in unit revenue for Hawaiian.

The company hopes to offset these costs with some moves of its own. One is to reconfigure some of its planes to less seating, which will allow the company to charge slightly higher prices than the competition. Also, the arrival of its fleet of A321neo planes to replace its older ones should further improve the flying experience for customers and significantly reduce fuel costs.

Hawaiian operates in a rather niche market, but the bigger operators are coming with their economies of scale and greater flight network. This one could go either way. Either Hawaiian will be able to move upmarket enough with a better in-flight experience to command a higher price point, or the competition will put significant pressure on margins. While some may be willing to make a bet one way or another, I want to wait this one out for a couple quarters to see how the company deals with this higher competition.

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